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March 13, 2013

On Portfolio Performance, Remember: Attribution Tells the Story

It’s still early 2013, and advisors around the country are doubtlessly still talking about 2012 investment performance with their clients. A big part of those discussions will be around individual portfolio manager results. It’s great, of course, when a manager meets or beats expectations. Conversations about those kinds of results are fairly straightforward. But experience tells us that a manager or two will have disappointed. In those instances, advisors are on the spot to explain why. Quantifying results is the nature of our business, and we suggest that advisors need to look to attribution to manage this important point of discussion with clients.

There Are Numbers…

When it comes to equity portfolios, it’s easy enough to compare results to indexes like the Russell 1000 or the MSCI EAFE. Typically, performance is analyzed versus a benchmark by running an attribution report that looks at stocks within different sectors. Below is an example of an attribution table that explains why a small-cap investment manager underperformed the Russell 2000 Index for the 2012 calendar year.

This type of attribution is a quick way to help tell the portfolio’s performance story. In a nutshell, the two columns towards the right—“Sector Weighting” and “Selection”—explain the bulk of the performance difference: Sector Weighting added 1.04% to total performance while Selection, primarily in the Consumer Discretionary sector, detracted 3.22%. In this example, the ‘story,’ then, would read something like this: “In 2012, weak stock selection, particularly among Consumer Discretionary issues, accounted for most of the portfolio’s underperformance versus its benchmark.”

…and Then There Are Numbers…

This kind of useful analysis is accurate as far as it goes, but the stock selection story may not go far enough. The fact is that portfolios have many different factors within them—lquality, volatility, market capitalization, style and so on—that result from their manager’s investment approach. As such, it’s useful to look at the impact that these factors had on performance.

Below, for example, is an attribution analysis for the same equity strategy for the same time period, this time looking at the ‘size’ factor:

This analysis shows that the strategy’s market cap weightings detracted 3.72% from its relative performance for the year, which overshadows the impact of stock selection. Indeed, this manager has a relatively high number of microcap stocks, and the portfolio’s overweight toward stocks in the smallest quintile detracted 2.46% from performance. With this report, an advisor can quickly and accurately tell investors that the portfolio’s bias towards microcap stocks is the main reason it did not keep up with its benchmark.

Other managers, meanwhile, like to invest in what are considered to be high-quality stocks, the resulting portfolios of which tend to lag their benchmarks during sharp market rallies. Advisors, as a result, have an opportunity to proactively explain this tendency to their clients. More than that, the advisor can put it all into numbers by running a return on equity attribution showing how the high-quality factor impacted performance over time.

Similarly, the volatility of a portfolio, usually measured by beta, can affect relative performance. Low-beta portfolios, for example, tend to underperform during sharp market rallies. Usually comprising high-quality companies with sustainable competitive advantages and lower levels of debt, these portfolios are typically out of favor in market rallies that prefer lower quality and higher-beta postures.

They All Add Up to the Story

In the end, an investment in an actively-managed portfolio of stocks is, intentionally or not, more than just buying a collection of publicly traded companies. The investment is actually in a collection of different factors that will perform better or worse in different market environments; that is why the phrase “stock selection” can be misleading. In practice, many traditional long-only portfolio managers hold stocks for several years, so analyzing and explaining which stocks they ‘selected’ each quarter can give the wrong impression.

Since stock selection and sector exposures by themselves don’t provide an entirely valid basis for judging managers and portfolio performance over time, it’s necessary to consider a variety of other factors, particularly those related to the manager’s investment strategy and the current market environment. Having a grip on the factors within portfolios is almost always a more efficient manner to evaluate performance behavior and explain past results. Said another way, running attributions on these different factors is a useful way to put actual numbers to the story.

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Author’s disclaimer: For investment professional use only. Past performance is not indicative of future results. The opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Information obtained from third party resources are believed to be reliable but not guaranteed. Any mention of a specific security is for illustrative purposes only and is not intended as a recommendation or advice regarding the specific security mentioned. Diversification does not guarantee a profit or guarantee protection against losses.